BUS-525, MANAGERIAL

ECONOMICS
COURSE CONVENER:
DR. TAMGID AHMED
CHOWDHURY

CHAPTER-3: CONSUMER
CHOICE

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Topics to discuss
Consumer Preferences
Budget Constraints
Consumer Choice
Revealed Preference
Marginal Utility and Consumer Choice

CONSUMER
BEHAVIOR
theory of consumer behavior: Description
of how consumers allocate incomes among
different goods and services to maximize their
well-being or utility or satisfaction.
Consumer behavior is best understood in three
distinct steps:
1. Consumer preferences (willingness factor)
2. Budget constraints (ability factor)
3. Consumer choices (demanding for the goods)

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CONSUMER
PREFERENCES
Few assumptions
Completeness: Preferences are assumed to be
complete. In other words, consumers can compare
and rank all possible baskets. Thus, for any two
market baskets A and B, a consumer will prefer A to
B, will prefer B to A, or will be indifferent between
the two.
Transitivity: Preferences are transitive.
Transitivity means that if a consumer prefers
basket A to basket B and basket B to basket C, then
the consumer also prefers A to C.
More is better than less: Goods are assumed to
be socially desirable. Consumer would prefer a
basket with 2X and 2Y over a basket of 4X and 3Y.

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CONSUMER PREFERENCES:
MEASURING UTILITY

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Indifference curve
(IC): Curve
representing all
combinations of
market baskets that
provide a consumer
with the same level of
satisfaction.

UTILITY FUNCTION
Formula that assigns a level of utility to
individual market basket. For example,
U(F, C) = F + 2C is the utility function
8 units food (F) and 3 units clothing (C) would
provide utility = 8 + 2(3) = 14.
6 unit foods and 4 units clothing will provide the
same utility.
But 4 units of food and 4 units of clothing do not
yield the same utility.

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INDIFFERENCE CURVE (IC)

1.

3.
4.

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2.

Features or characteristics of IC
IC is downward slopping (because, with the fixed
income, a consumer has to reduce consumption of a
product when consumption of another product rises)
IC is convex to the origin (because of diminishing
marginal rate of substitution)
ICs cant intersect each other (by doing so, it
violates transitivity rule)
Higher the indifference curve more is the
satisfaction (because in a higher IC, consumer gets
more products than a lower IC)

2ND FEATURE OF IC
Marginal rate of
substitution: marginal
rate of substitution
(MRS) Maximum
amount of a good that a
consumer is willing to
give up in order to obtain
one additional unit of
another good.
IC follows diminishing
marginal rate of
substitution

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EXCEPTIONS OF IC
Substitute products: Two goods for which the
marginal rate of substitution of one for the other is
a constant.
perfect complements Two goods for which
the MRS is zero or infinite; the indifference curves
are shaped as right angles.

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MATHEMATICAL EXAMPLES
Suppose that Rahim and Karim spend their incomes
on two goods, food (F) and clothing (C). Rahims
preferences are represented by the utility function
U(F,C) = 10FC , while Karims preferences are
represented by the utility function U(F,C)= 0.20F 2C2.
With food on the horizontal axis and clothing on the
vertical axis, identify on a graph the set of points that
give Rahim the same level of utility as the bundle
(10,5). Do the same for Karim on a separate graph.
On the same two graphs, identify the set of bundles
that give Rahim and Karim the same level of utility as
the bundle (15,8).
Do you think Rahim and Karim have the same
preferences or different preferences? Explain.

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BUDGET LINE
It shows different combinations of goods and services that an
individual can buy with his/her income.
Show the impact of change in income on budget line

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Slope of the budget line is the

price ratio of two goods under
consideration

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SLOPE OF THE BUDGET LINE

Line AG (which
passes through points
B, D, and E) shows
the budget associated
with an income of
$80, a price of food of
PF = $1 per unit, and
a price of clothing of
PC = $2 per unit.
The slope of the
budget line (measured
between points B and
D) is PF/PC =
10/20 = 1/2.

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CHANGE IN BUDGET LINE WITH A CHANGE IN PRICE

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Price Changes A
change in the
price of one good (with
income unchanged)
causes the budget line
to rotate about one
intercept.
When the price of food
falls from $1.00 to
$0.50, the budget line
rotates outward from
L1 to L2.
However, when the
price increases
from $1.00 to $2.00,
the line rotates
inward from L1 to L3.

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MATHEMATICAL EXAMPLE

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Samira buys five new college textbooks during his

first year at school at a cost of $80 each. Used
books cost only $50 each. When the bookstore
announces that there will be a 10 percent
increase in the price of new books and a 5 percent
increase in the price of used books, Samiras
father offers him $40 extra.
A) What happens to Samiras budget line?
Illustrate the change with new books on the
vertical axis.
B) Is Samira worse or better off after the
price change? Explain.

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CONSUMER CHOICE: FINDING BEST

POINT
Consumers
satisfaction will be
maximum at a point
where IC and budget
line are tangent to
each other.
Utility is maximized
at the point where
MRS = price ratio of
two goods
At point B, MRS = (-10/10) = 1 which is
not equal to price
ratio.

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OTHER EQUILIBRIUMS
Show the optimum point in case of substitute
products and in case of complement products
Show the change in equilibrium if income
increases
Show the change in equilibrium if price of a
product increases

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diminishing marginal utility Principle that as

more of a good is consumed, the consumption of
additional amounts will yield smaller additions to utility.
The additional consumption of food will give a total
increase in utility of MUF. F. On the other hand because
of more F consumption, C consumption will decline and
thus total reduction would be MUC. C.
These two will be balanced thus:
0 = MUF (F) + MUC (C)
Rearranging, -(C/ F) = MUF/MUC
MRS = MUF/MUC
PF/PC = MUF/MUC
Principle that utility is maximized when the
consumer has equalized the marginal utility per dollar of
expenditure across all goods.

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GASOLINE RATIONING
When a good is rationed, less
is available than consumers
would like to buy. Consumers
may be worse off. Without
gasoline rationing, up to
20,000 gallons of gasoline
are available for consumption
(at point B).
The consumer chooses point
C on indifference curve U2,
consuming 5000 gallons of
gasoline.
However, with a limit of 2000
gallons of gasoline under
rationing (at point E), the
consumer moves to D on the
lower indifference curve U1.

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MATHEMATICAL EXAMPLE
Sonia has a monthly income of $200 that she
allocates among two goods: meat and
potatoes. Suppose meat costs $4 per pound
and potatoes $2 per pound. Draw her
budget constraint.
Suppose also that her utility function is
given by the equation U(M, P) = 0.20M2P2.
What combination of meat and potatoes
should she buy to maximize her utility?

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